The Financial Accounting Standards Board Web site already offers a detailed discussion about how to account for life settlements.
That means that life settlements must be here for the long haul and that we must determine how we can best use life settlements in the comprehensive financial plans we create and maintain for our most affluent clients.
For moderately affluent clients, life settlements can provide monies for liquidity and cash flow needs, but few high-net-worth individuals who employ wealth transfer strategies that include life insurance have cash flow issues. So, why would the potential liquidity event of a life settlement become a viable part of an advanced wealth transfer strategy?
Let’s examine the plain vanilla irrevocable life insurance trust first. With the ILIT structure, one major obstacle is how to transfer adequate money or property to the trust, to cover the premiums due without having the grantor pay an inordinate amount of gift taxes. The traditional way of handling this is to give Crummey withdrawal rights to as many different beneficiaries as possible, to maximize the number of annual exclusion gifts that can be made to the trust. This allows clients to circumvent the gift tax due on the funding. But even if the grantor has 10 Crummey beneficiaries and splits the gift with his or her spouse, he or she could only fund $220,000 worth of premiums.
If this individual were a 67-year-old male of standard insurability, he could probably secure only $7.3 million of level death benefits guaranteed to age 100. Such a person is expected to live to age 86.4 and the cumulative annual premiums paid up to that point would be $4.268 million. The death benefit to heirs without taking into account opportunity cost or taxes is $7.3 million. While this is not an insignificant benefit, it is indeed far short of solving any large estate tax issues or providing significant liquidity for wealth transfer planning.
The solution? Premium financing is the traditional alternative to the straight-pay scenario described above. The intricacies of a complete premium financing strategy are beyond the scope of this discussion. But suffice it to say, there is a significant amount of interest-rate risk that requires careful monitoring by an experienced trustee who understands the lending market and has access to alternative funding sources.
To illustrate the potential benefits of employing a premium financing strategy, let’s assume the same 67-year-old standard health male can borrow $1 million per year at 5% annual interest. If he were to contribute the $1 million borrowed each year to the policy and at the same time take the $220,000 that he would have used to make the annual exclusion gifts to the trust under the straight-pay alternative described above in order to pay the annual interest on the loan, he would be able to support a $9.25 million increasing death benefit policy.
By age 86.4 the total interest paid would be $4.268 million, the same amount as the cumulative annual premiums that would have been paid on the $7.3 million level death benefits policy described above. The total outstanding loan would have grown to $24,349,879 and the gross death benefit would have grown to $34,938,007. After satisfaction of the loan, the net in trust would be $10,588,128. The net result exceeds the straight-pay alternative above by $3,288,128 and the outlay was identical.
The risk of this strategy lies in the financing. If the average interest rate had been 6% instead of 5%, the total loan would have grown to $29,358,393. The gross death benefit would still have been $34,938,007 and the net in trust after satisfaction of the outstanding loan would have dropped to $5,579,614, or $1,720,386 less than the straight-pay option above. This simple illustration highlights the inherent sensitivity to interest rates that is associated with premium financing strategies.
Enter life settlements. With life settlements, it may be possible to obtain net death benefits that approximate the favorable metrics that premium financing affords in a stable and low interest rate environment while, at the same time, lowering the level of risk to not much more than the risk level of the straight-pay option.
If the 67-year-old grantor opts to “minimum fund” a maximum benefit life insurance policy with the option of “making up” the premium in the 10th year, he would be able to purchase $10 million worth of coverage for the $220,000 premium. However, a $10 million increasing death benefit policy funded as described here would likely lapse around the insured’s age of 83 without the makeup premium.
This particular scenario is ideal for a life settlement. If the policy is held in trust and the trustee elects to “settle” a portion of the insurance in the secondary market at age 77, the proceeds from said settlement would be about 20% of the face value. So, a $5 million settlement retains half of the increasing death benefit insurance in force and affords the trustee a $1 million windfall to infuse the remaining policy.
This $1 million will not create any gift tax consequences for the grantor. Bear in mind that for the first 10 years of this structure, the net death benefits far exceed both the premium financing and straight-pay options. If the grantor unexpectedly passes away, this structure would provide the maximum benefits. At the insured’s age of 86.4, the death benefit will have grown to $8,431,160. This is a 15.5% improvement over the straight-pay option and a 20% worsening from the optimal premium financing structure. However, the improvement over the 6% premium financing structure is 51% (the difference between $8,431,160 and $5,579,614).
In the end, the life settlement option is another valuable financial planning tool that advisors can use when working with high-net-worth clients. It adds more benefit than a straight-pay option would while possibly reducing clients’ exposure to interest rate risk.
Ralph C. Wileczek, CPA, CFP, CTFA, is a vice president and senior private client advisor at Wilmington Trust Company, Wilmington, Del. He can be reached at firstname.lastname@example.org.
There is an inherent sensitivity to interest rates associated with premium financing strategies
If interest rates go up, a life settlement might be better for some clients than premium financing would be.
The Client: A healthy 67-year-old.
The Problem: Getting the most out of the $220,000 limit on use of Crummey withdrawal rights to fund an irrevocable life insurance trust.
a) Premium financing, assuming 5% annual interest and a $9.25 million increasing death benefit policy.
Net in trust at age 86.4: $10,588,128
b) Premium financing, assuming 6% annual interest and a $9.25 million increasing death benefit policy.
Net in trust at age 86.4: $5,579,614
c) Buying $10 million in minimally funded benefits that likely will lapse around age 83, and selling half and keeping half.
Net in trust at age 86.4: $8,431,160
Source: Ralph C. Wileczek